Testing poterba’s asset-market approach to modelling the house price dynamics

For years the housing market sector has been an ardent issue of both researchers and the non-academic public. House prices are a continuous preoccupation for people, since they directly influence our daily lives and for many people in Europe, the house they live in is the main acquisition of their lifetime. The purpose of the current paper is to test whether the asset market model of house price dynamics proposed by Poterba (1984) holds. I show that the arbitrage equation suggested by Poterba (1984) does not fully describe the short run house price dynamics and that people do not form rational expectations. The public rather has adaptive expectations regarding the evolution of house prices and rents, since current price to rent ratios can be predicted based on past price to rent ratios. I find that in Bulgaria, Lithuania and the UK there is seasonality, which is why the arbitrage equation might not work .The tests are performed using four panels with different cross-sectional combinations of the following six European countries: Bulgaria, Czech Republic, Estonia, Lithuania, Poland and the UK. The econometric method is two stage least squares and the data is quarterly time series from 2000 until 2006.